Let ’em Shrink

The Editors May 3, 2010 - 12:41pm

When President Barack Obama brought his pitch for stronger financial regulation to New York City’s Cooper Union in April, he had the wind at his back.

News of big profits and bonuses at bailed-out financial institutions, together with the Securities and Exchange Commission’s recent announcement of a lawsuit against Goldman Sachs, had rekindled anger at Wall Street. A surge of free-floating populist wrath that conservatives had tried to direct against President Obama’s “big government” domestic agenda seemed at last to have found its proper target: those whose bad decisions wrecked the economy.

But the president did not come to New York to gloat. He was in a conciliatory mood, looking for allies, not scapegoats. He gently reassured Wall Street executives that he believed in “the power of the free market” and in “a strong financial sector.” Sounding a bit like Herbert Hoover, he said that finance is “part of what has made America what it is.” But then, sounding very much like a man intent on reform, he said that “a free market was never meant to be a free license to take whatever you can get, however you can get it.”

Revoking that license, which financiers have been allowed to issue to themselves for the better part of three decades, will still be difficult; but the recent news from Wall Street may have temporarily drowned out the din of lobbyists on Capitol Hill. Some Republican lawmakers, smarting from their defeat over health-care reform, hoped to take their revenge on financial reform, but they’re quickly discovering there’s no political advantage in blocking tougher rules for bankers.

Some of them, including Senate Minority Leader Mitch McConnell of Kentucky, have tried to get around this problem by mischaracterizing the president’s plan as another “taxpayer-funded bailout.” In his Cooper Union speech, Obama called McConnell’s description “not factually accurate,” and even some Republican senators seem to agree with the president’s assessment. Sen. Bob Corker (R-Tenn.) aptly compared McConnell’s words to another piece of right-wing rhetoric that turned out to be utterly false: “This is like in the health-care debate [with] death panels,” Corker said.

In fact, the plan backed by Democrats is designed to protect taxpayers from having to rescue troubled financial institutions: those judged too big, or too interconnected, to fail would have to contribute to a special fund that would cover the cost of liquidating insolvent firms. The obvious alternatives are to let taxpayers continue to fund bailouts, or to let these big firms fail without government intervention. The latter is what some Republicans say they want—including Republicans like McConnell who recently had an opportunity to let the banks fail but instead decided to vote for the Troubled Asset Relief Program. TARP was, by anyone’s definition, a taxpayer-funded bailout. It’s hard to believe McConnell has already forgotten why he supported it. But he should be reminded: The government had just given the “let ’em fail” method a try with Lehman Brothers, and the results were not good.

The real problem with the Democrats’ plan is that it does not do enough to keep banks from getting too big to fail in the first place. The bill now before the Senate would allow a “financial stability oversight council” to lay down “strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity,” but it would leave the strictness of these rules up to the council, in the hope that regulators will never again be duped or seduced the way they were during the recent housing bubble—and a few times before that.

Better to equip regulators with good regulations upfront. The Senate bill should adopt the specific capital-reserve requirements included in the House bill passed in December. It should also add some version of the legislation recently introduced in the Senate by Sherrod Brown (D-Ohio) and Edward E. Kaufman (D-Del.), which would limit the size of banks by requiring them to keep their nondeposit liabilities to no more than 2 percent of GDP. That would force several of the nation’s largest banks to become smaller and, therefore, safer. Not only do such banks pose a risk to the entire economy; they also enjoy an unfair advantage in the bond market. Investors will lend money at cheaper rates to banks they know will be bailed out by the government. That helps explain why the financial industry has lately grown much more concentrated. Fifteen years ago, the country’s six largest banks had assets worth 17 percent of GDP. Today, it’s up to 63 percent. Even Herbert Hoover would be appalled. Such a state of affairs is bad for the economy and bad for democracy. A careful populism, as focused on good policy as on good politics, would use financial reform to break up the biggest banks before they break.